Is the CMBS Party Over?

The dollar volume of mortgages on commercial real estate hit the public marketplace at a record level in March, according to the Barron's/John B. Levy & Co. National Mortgage Survey. The market for commercial mortgage-backed securities absorbed some $29 billion, compared with the previous record of slightly less than $23 billion set in January 2005.

But don't look for this party to continue; the next few months will show modest volume in CMBS, largely because of a downtrend in sales of income property, most of which trigger fresh financing.

According to Real Capital Analytics, January sales of single assets worth $5 million or more were down 20% compared with the same period last year. The extent of the trend varied by property type, with apartments down a scant 1% and shopping centers off a whopping 47%.

It's the first time in over two years that sales volume has dropped for all core property types, says Bob White, president of Real Capital Analytics. February sales were up 17% from the corresponding period last year, but that was almost entirely driven by two large transactions involving office buildings.

Two significant trends have surfaced. First, capitalization rates — the inverse of a price-earnings ratio — have stopped falling and, in fact, have risen as much as a quarter of a percentage point in some markets. Second, more properties are being marketed with an asking price. At the height of the market frenzy, properties were routinely marketed with no asking price.

Lenders push the envelope

Though 10-year Treasury yields rose after the Federal Reserve again raised short-term interest rates in late March, prospects for scaling back leverage on commercial real estate might seem in order. But not yet. All signs point to the flood of capital into the market continuing, and as that capital chases fewer loan originations higher leverage is here for a while longer.

We don't suspect author Rita Mae Brown had commercial real estate in mind when she noted that “one of the keys to happiness is a bad memory.” But today's investors have surely forgotten the real estate carnage of the early 1990s. As interest rates have risen, clever lenders have reduced the debt-service coverage required for new financing.

For example, in the first quarter of 2004 the net operating income of properties was a robust 1.60 times the required debt service, according to Moody's Investors Service. By the first quarter of this year, that figure had declined markedly to 1.37 times. To be sure, those numbers include a number of large low-leverage loans. In the first quarter of 2004, only 19.4% of the mortgages marketed by CMBS conduits showed debt-service coverage ratios below 1.30 as calculated by the issuers. That rose to 28.1% in the first quarter of 2005 and has now skyrocketed to 53.4% in this year's first quarter. Such loans would clearly be much riskier if the economy turns down.

Land offerings enter the mix

One of the most innovative real estate financings in years came to market recently in the form of a $570 million offering from Barclays Capital. Rather than securitizing mortgages on income-producing property, Barclays floated loans on home building lots that were the property of three of the five largest home builders in the country: Lennar Corp., Pulte Homes and Centex Corp. Through an elaborate structure, the loans were offered to investors who have been searching high and low for additional yield.

The offering was heavily oversold, each tranche being oversubscribed by at least nine times. With that sort of reception, it's clear that other land offerings will be brought to market. The deal carried a maximum leverage of only 67%, and also required the builders, each rated investment grade, to put up additional funds if the leverage climbed above certain preset levels. It will be interesting to see whether future additions, from Barclays or competitors, will require this kind of a belt-and-suspenders approach.